China Indomitable Developers – Passing the Debt Parcel

China’s property developers have shown themselves to be the great survivors of China’s economy. After two years of having sales squeezed from one end and their supply of credit squeezed from the other, the industry has so far managed to hold out against steep price cuts and significant consolidation.

In large part that’s because developers have been able to tap non-traditional sources of finance – albeit at a much higher cost – even when Beijing thought it had turned off the tap. True to form, the sector has found itself new lenders of last resort to at least partially avoid the latest crunch, but assuming Beijing doesn’t relax housing restrictions before the most recent round of financing matures, this time developers might have trouble avoiding selling off their assets or pushing apartments out the door at whatever they can get.

Bloomberg News

After bank loans started getting hard to come by in late 2010, the developers turned to trust companies for financing on a massive scale. The banking regulator started tightening trust financing mid-last year, and more recently has made it difficult for trusts to roll over loans to developers that are maturing. According to data from the China Trustee Association, outstanding trust financing to the property sector at the end of March was down from the end of last year (in Chinese). That’s the first ever decline since early 2010, when data first became available.

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“The government’s crackdown on trust funding as an artery for financing is just the latest of its measures to force developers to bring down property prices,” said Richard David, chief executive of Shanghai-based real estate firm Treasury China Trust. “There is going to be significant disruption to developers that rely on trust funding.”

China’s asset management corporations – initially set up over a decade ago to help the major banks deal with their nonperforming loans – and property focused private equity funds are now wading in, providing cash so that the developers can pay off their trust loans. But while the funds see an excellent investment opportunity – as long as they pick projects judiciously – the AMCs are at least partly motivated by different concerns.

It’s not just the developers that face a liquidity crisis, but the trusts as well. While a loan default would deliver a trust a windfall in collateral – sometimes up to three times the value of the loans – the trusts need to repay their investors immediately. It might take months to find a buyer for a stake in a property development, or even longer – and at depressed prices – if a wave of such assets came onto the market at once.

The emergence of the AMCs has helped avert a potential liquidity crunch among the lightly capitalized trusts. Still, market watchers say it’s likely that some trusts will still need to dip into their own capital to meet redemptions.

So far the AMCs would appear not to be overly exposed to property.

“As a percentage of all nonperforming loans we’ve bought this year, trust NPLs account for less than 10%,” Li Xin, vice president at China Orient Asset Management Corp, recently told The Wall Street Journal. She said her firm started doing property deals with the trusts in the fourth quarter of last year.

According to an executive at another of the four AMCs, his firm has invested between 5 billion yuan and 7 billion yuan in distressed property this year — a small portion of the roughly 70 billion yuan ($11 billion) worth of trust financing that has already matured this year according to securities firm China International Capital Corporation.

Things are likely more risky for private equity investors. While property funds are a major fixture in the U.S. market, they’re a relatively new development in China, with a wave of funds forming last year to take advantage of developers’ financing needs.

“I thought that was a very dangerous situation because these people didn’t know what fund management actually means,” Greg Peng, president of property investment fund AT Investment Management, said of some of the newly formed funds. Mr. Peng, who used to run Merrill Lynch’s property investments in China, closed the first tranche of his fund in the third quarter of last year, raising one billion yuan from local investors, and plans to have invested 3 billion yuan by the middle of next year.

With little experience, bad choices could leave many investors with moribund projects rather than the super-charged returns they’re expecting.

Not all the funds are fully independent like Mr. Peng’s. Some are tied to specific developers, operating as in-house fundraising platforms to provide cash for existing projects, or helping developers make acquisitions.

Property prices are already coming down, and developers are already selling projects – or stakes in projects – to get the cash to be able to pay off their debts. The question is how much more will they come down – and is the emergence of the funds and AMCs as lenders of last resort just delaying the inevitable.

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